Unit 3: Aggregate Demand

Aggregate demand(AD):

• Shows the amount of Real GDP that the private, public and foreign sector collectively desire to purchase at each possible price level. 
• The relationship between the price level and the level of Real GDP is inverse. 

Why aggregate demand is downward sloping:

• Wealth effect: 

• higher prices reduce purchasing power of money.
• This decreases the quantity of expenditures
• Lower price levels increase purchasing power and increase expenditures
• Example: If the balance in your bank was $50,000, but inflation erodes your purchasing power, you will likely reduce your spending. 

• Interest-rate effect: 

• As price level increases, lenders need to charge higher interest rates to get a REAL return on their loans. 
• Higher interest rates discourage consumer spending and business investment. 
• Example: Increase in prices leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business. 
• As price goes up GDP demand goes down (and Vice versa)

• Foreign trade effect:

• When US price level rises, foreign buyers purchase fewer US goods and Americans buy more foreign goods. 
• Exports fall and imports rise causing real GDP demanded to fall. (Xn decreases)
• Example: If prices triple in the US, Canada will no longer buy US goods causing quantity demanded of US products to fall. 

Shifts in AD:

• There are two parts to a shift in AD
• A change in C, Ig, G, and/or Xn 
• A multiplier effect that produces a greater change than the original change in the 4 components. 
• Increase in AD = shift to the right
• Decrease in AD= shift to the left

Determinants of AD:

• ▲in consumer spending(C)

• Consumer wealth: Boom in the stock market
• Consumer expectations: People fear a recession
• Household indebtedness: More consumer debt
• Taxes Decrease in income taxes

• ▲in Investment spending(Ig)

• Real Interest rate: Price of borrowing dollars
• If interest rate increases…
• If interest rates decrease…
• Future business expectations: High expectations
• Productivity and Technology (New robots)
• Business taxes (Higher corporate taxes mean)

• ▲in government spending(G)

• War
• Nationalized Health care
• Decrease in defense spending

• ▲in Net exports(Xn)

• Exchange rates: If the US dollar depreciates relative to the euro
• National Income compared to abroad:If a major importer has a recession. If the US has a recession. 

*AD=GDP=C+Ig+G+Xn

Government spending:

• More government spending (AD the the right)
• Less government spending (AD to the left)